Are you one of the investors who could be caught out by a higher tax on dividends? What you need to know - and how to beat it

The Government's crackdown on self-employed National Insurance caused such a furore that it scrapped it in a week - but private investors were also hit hard by the Budget.

Their plight has been less-widely reported, but research from the Share Centre has suggested that as many as 90,000 investors - many of whom are pensioners who rely on dividend income to pay their bills each month - are facing an annual drop in income next year.

This is a result of the Chancellor's proposal to cut the tax-free dividend allowance from £5,000 a year to just £2,000 from April next year.

Philip Hammond's Budget caused uproar among the self-employed but it hurts investors too

A second u-turn from Philip Hammond, this time on a tax that was intended to hit wealthy small business and company directors, is unlikely - but there are a few ways pensioners and other investors can mitigate the effects of this impending income shock.

What's changing?

The tax-free dividend allowance was originally set at £5,000. It meant that investors could earn up to £5,000 a year in dividend payments without paying a penny of tax.

Many self-employed people operate through their own companies, and pay themselves in dividends rather than a salary.

The £5,000 tax-free allowance made this option more desirable.

However, from April 2018 the Chancellor is reducing the threshold to £2,000, as part of measures designed to level the playing field between the employed and the self-employed.

However it is not just the self-employed who will be affected - the change could penalise those who are using dividends to fund their retirement.

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HOW THIS IS MONEY CAN HELP

Many older investors look specifically to invest in companies, investment trusts or funds that pay regular dividends in order to supplement income from their pension.

This income is currently protected from tax up to £5,000, boosting the tax free income it's possible to take in addition to the personal allowance which is currently set at £11,000 and any income you take out of your Isa investments.

From April 2018, dividend income above £2,000 and not held within an Isa will be taxed at your income tax rate - which could be up to 45 per cent.

Who's at risk?

The Share Centre research suggested the reduction in the tax free allowance will typically affect investors with portfolios over £50,000.

Darren Cornish: Pensioners will be hit by the cut to dividend tax relief

Assuming a 4 per cent yield, a portfolio size of £50,000 would generate dividend income of around £2,000 - any further dividend income will then become taxable at the rate you pay income tax.

Many of those affected will have started investing with a small portfolio and not considered that they would grow their investments to the £50,000+ value they have now achieved.

Other investors would have seen the previous allowance of £5,000 and considered that they would be unlikely to earn more than this in dividends and as such felt they didn’t need an Isa.

Some have been granted company shares by a previous employer and have placed these into a standard investment account without thinking about the benefits of an Isa. Some will have used their full Isa allowance (in years gone by when it was much lower) and thus had to use a standard investment account for additional investments.

And there are individuals who may not have been eligible to open an Isa - for example those who are non-UK residents.

Darren Cornish, of DIY investing platform The Share Centre, explains: 'A significant number of our customers have portfolios over £50,000 that are not being held within a tax efficient wrapper such as an Isa.

'These are not company directors paying themselves through dividends – many are pensioners who turned to investing because interest rates were so low. They could see their tax liability increase by hundreds or possibly thousands when the allowance is reduced next year.

'Taken across the industry as a whole we estimate there are around 90,000 investors in this position.'

Is there any way to avoid an income drop?

Depending on how much of your Isa and pension allowances you've used up, you may be able to shelter some of your investment income and mitigate the drop in your annual income.

Dividend income earned inside an investment Isa is automatically tax-free and it is possible to transfer investments from a share account to some Isas - at a cost.

The transfer will trigger the need to sell and buy back your investments, meaning you may crystallise gains, which will be liable to capital gains tax, and the sell price is likely to be marginally lower than the buy price. There will also be trading costs and depending on the investment, there may also be stamp duty levied on the purchase.

Currently £15,240 per tax year can be held within an Isa, rising to £20,000 from 6 April 2017.

'We are contacting all our customers who are likely to be affected by the reduction in the tax free dividend allowance next year to let them know their options,' says Cornish.

'One thing they may wish to consider is selling their investments and repurchasing them within an Isa, sometimes known as ‘Bed and Isa’. We only charge dealing commission on the sale, although investors need to be aware that they may need to pay stamp duty, if applicable, and that their repurchased holding will be slightly smaller due to the ‘sell’ price being lower than the ‘buy’ price.

'However once investors have made this switch they have the peace of mind of knowing that their future dividend income is protected.'

Should you bother to transfer into an Isa?

The benefit is that the investments are then in the Isa tax-efficient wrapper so neither capital growth nor dividends would be subject to any further taxation.

You'll also avoid a tax bill that might otherwise apply due to the reduced dividend allowance.

Transferring into an Isa may incur some upfront costs, but once you've done it, you'll have an account to continue investing in knowing you have that tax efficiency.

Some brokers also offer a flexible Isa facility meaning that money can be taken out of an Isa and replaced later in the same tax year without losing your overall allowance.

Cornish says: 'So an Isa becomes more like a bank account should a customer have a short-term need to use some of the monies - although we wouldn’t generally expect to see an investment Isa used in this way as they are generally intended for medium to long-term investing.'

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